Why more investors are buying dividend-paying stocks, not bonds

Current market conditions are making dividend-paying stocks a cheap long-term investment, but the end of Bush tax cuts could spoil the party. Image: Thinkstock

Investors are shopping for dividend-paying stocks in an unusual market environment. Record-low interest rates make putting money in bank accounts illogical. Despite a sputtering economic recovery, companies sitting on huge piles of cash can afford generous dividend payouts. The number of companies paying more in dividends than the average bond yield is at a 15-year high. The dividend tax rate is low. Dividend-paying stocks can provide a revenue stream and serve as a hedge against inflation. But if the Bush tax cuts expire, the value of dividend-paying stocks could sharply drop.

Dividend-paying stocks are hot right now

Dividend-paying stocks are hot right now because of several factors. Historically, bond yields far outstrip that of stock dividends. But more U.S. stocks are paying more than bonds than at any time in at least 15 years, according to Bloomberg. Companies raised payouts by 6.8 percent in the second quarter. Increasing worker productivity during the downturn has made companies cash-rich. Dividend-paying stocks are cheap, thanks to record-low interest rates, a projected growth in profits of 36 percent in 2010 — the fastest pace in two decades — and a slowing economy. A 10 percent drop in the S&P 500 since April also pushed up dividend yields relative to share price. It’s giving investors the opportunity to buy stocks that pay more than bonds, at inexpensive price-to-earnings multiples.

Why dividend-paying stocks are popular

Investors see stock dividends as a safety net in a recession and a hedge against inflation during a recovery as well, according to Linda Stern at ABC News. During a recession, if stock prices go down and bonds lose value, investors can always cash a dividend check. During an economic recovery, if inflation kicks in, dividends can follow suit. However, dividend-paying stocks carry risk. Stern uses Bank of America and Citicorp stocks, which saw generous dividends disappear during the credit crunch, as an example. Plus, if the Bush tax cuts are allowed to expire on Dec. 31, dividends could again be taxed like ordinary income — at rates as high as 39.6 percent. Currently the dividend tax rate is  15 percent — the same as capital gains.

How to pick dividend-paying stocks

Now is the time to look at dividend-paying stocks as a long-term investment, according to Matt Theal at MarketWatch. Theal said investors should look for companies that pay dividends higher than the return in the credit markets. Currently 68 companies in the S&P 500 yield more than 3.78 percent, the average rate in the credit markets since 1995. Theal used a stock-screener to search for S&P 500 companies paying a dividends yield of 3.78 percent that sell under 12 times earnings. The screen returned 25 companies, including Bristol-Myers, Excelon Corp., Reynolds American Inc. and Verizon Communications Inc.